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Boudreaux and Palagashvili on Worker Productivity and Pay

In the March 7th, 2014, edition of the Wall Street Journal, then-GMU Econ student (now SUNY-Purchase econ professor) Liya Palagashvili and I did our best to bust the myth that worker pay in the U.S. has failed to keep pace with worker productivity. I can now share the full text of this op-ed here. ‘Tis below the fold.

Donald Boudreaux and Liya Palagashvili: The Myth of the Great Wages ‘Decoupling’: There is no disconnect between productivity and worker pay if you use more accurate measures.

By Donald J. Boudreaux and Liya Palagashvili

March 6, 2014 7:23 p.m. ET

Many pundits, politicians and economists claim that wages have fallen behind productivity gains over the last generation. This “decoupling” explains allegedly stagnant (or in some versions of the story, declining) middle-class incomes and is held out as a crisis of the market economy.

This story, though, is built on an illusion. There is no great decoupling of worker pay from productivity. Nor have workers’ incomes stagnated over the past four decades.

The illusion is the result of two mistakes that are routinely made when pay is compared with productivity. First, the value of fringe benefits—such as health insurance and pension contributions—is often excluded from calculations of worker pay. Because fringe benefits today make up a larger share of the typical employee’s pay than they did 40 years ago (about 19% today compared with 10% back then), excluding them fosters the illusion that the workers’ slice of the (bigger) pie is shrinking.

The second mistake is to use the Consumer Price Index (CPI) to adjust workers’ pay for inflation while using a different measure—for example the GDP deflator, which converts the current prices of all domestically produced final goods and services into constant dollars—to adjust the value of economic output for inflation. But as Harvard’s Martin Feldstein noted in a National Bureau of Economic Research paper in 2008, it is misleading to use different deflators.

Different inflation adjustments give conflicting estimates of just how much the dollar’s purchasing power has fallen. So to accurately compare the real (that is, inflation-adjusted) value of output to the real value of worker pay requires that these values both be calculated using the same price index.

Consider, for instance, that between 1970-2006 the CPI rose at an average annual rate of 4.3%, while the GDP deflator rose only 3.8%. Economists believe that such a difference arises because the CPI is especially prone to overestimate inflation. Therefore, much of the increase in the real purchasing power of workers’ pay is mistakenly labeled by the CPI as mere inflation.

Mr. Feldstein and a number of other careful economists—including Richard Anderson of the St. Louis Federal Reserve Bank and Edward Lazear of the Stanford University Graduate School of Business—have compared worker pay (including the value of fringe benefits) with productivity using a consistent adjustment for inflation. They move in tandem. And in a study last year, João Paulo Pessoa and John Van Reenen of the London School of Economics compared worker compensation and productivity in both the United States and the United Kingdom from 1972-2010. There was no decoupling in either country.

The empirical reality in both countries is consistent with economic reasoning. Firms cannot afford a misalignment of their workers’ pay and productivity increases—the employees will move to other firms eager to hire these now more productive workers. Higher economy-wide productivity, after all, means that workers add more to the bottom lines of employers throughout the economy. To secure the services of these more-productive workers, firms bid up worker pay. This competition for labor services is what links pay to productivity.

Competitive markets also deliver the goods, so to speak, to workers in their role as consumers. Higher productivity means the prices of consumer goods and services decline as output increases. As this happens, workers’ spending power—their real income—is enhanced.

The claim that ordinary Americans are stagnating economically while only “the rich” are gaining is also incorrect. True enough, membership in the middle class seems to be declining—but this is because more American households are moving up.

The Census Bureau in 2012 compiled data on the percentage of U.S. households earning annual incomes, measured in 2009 dollars, in different income categories (for example, annual incomes between $25,000 and $35,000). These data reveal that between 1975 and 2009, the percentage of households in the low- and middle-income categories fell. The only two categories that saw an increase were households earning between $75,000 and $100,000 annually, and households earning more than $100,000 annually. Remarkably, the share of American households earning annual incomes in excess of $100,000 went to 20.1% in 2009 from 8.4% in 1975. Over these same years, households earning annual incomes of $50,000 or less fell to 50.1% from 58.4%.

This household-income trend can’t just be dismissed, as some analysts do, by noting that it was amplified by the greater number of married women in the workforce. The increase in income earned by these women itself reflects greater economic productivity. Women’s increased employment has been facilitated by lower-priced and higher-quality home appliances, prepared meals and other modern conveniences.

Households in the past enjoyed income earned in the market by the husband, with meal preparation, dishwashing and the like performed by the wife. The women who engaged in this household production were not paid a wage in the market, but their work had real economic value to the household (and to the economy). Households today enjoy market incomes earned by both spouses, while the time necessary for household work has been reduced thanks to microwave ovens, automatic dishwashers and other inventions that are themselves reflections of a thriving marketplace.

Middle-class stagnation and the “decoupling” of pay and productivity are illusions. Yes, the U.S. economy is in the doldrums, thanks to a variety of factors, most significantly the effect of growth-deadening government policies like ObamaCare and the Dodd-Frank Act. But by any sensible measure, most Americans are today better paid and more prosperous than in the past.

Mr. Boudreaux is an economics professor at George Mason University, where Ms. Palagashvili is a graduate student in economics; she is also a visiting Ph.D. fellow in the economics department at New York University.